Does the Constitution Require a Debtor to Be Insolvent to File for Bankruptcy

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Nov 2003

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The death of Texas tycoon J. Howard Marshall II on Aug. 4, 1995, has generated some interesting, if not
noteworthy, bankruptcy litigation beginning with the chapter 11 filing of Vickie Lynn Marshall, a/k/a Anna Nicole
Smith. The latest saga involves sons J. Howard Marshall III and E. Pierce Marshall (Pierce), who are litigating in
the U.S. Bankruptcy Court for the Central District of California. Debtors J. Howard Marshall III and his wife, Ilene,
filed a chapter 11 bankruptcy petition on July 11, 2002, following the entry of a judgment in favor of Pierce in the
sum of $11 million plus costs in the Texas probate case of their father's estate.

The debtors subsequently filed a reorganization plan, and in response to that plan, Pierce raised statutory and constitutional objections to confirmation. The court rejected the statutory objections, including the argument that the plan had not been filed in good faith, as reported in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Marshall, 2003 WL 22075701 (Bankr. C.D. Cal., Aug.
26, 2003)</a>, and considered the constitutional issues raised by Pierce in a separate ruling reported in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Marshall,
2003 WL 22075703 (Bankr. C.D. Cal., Sept. 03, 2003)</a>.

Pierce's constitutional argument focused on the issue of the debtors' solvency. It was Pierce's contention that the
Constitution limits bankruptcy filings to only those individuals or entities that are insolvent under a balance-sheet
test.<a href="#1" name="1a">1</a> Pierce argued that because the debtors' assets exceeded their liabilities, the debtors were solvent and therefore
ineligible for chapter 11 bankruptcy protection. Pierce concluded that if the debtors were ineligible for bankruptcy
protection, the court certainly could not confirm a reorganization plan.

At the outset, Pierce did not claim that insolvency is a statutory requirement for filing a bankruptcy. This view was
firmly rejected by the Ninth Circuit in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… Capital Inc. v. Sylmar Plaza L.P. (In re Sylmar Plaza L.P.), 314
F.3d 1070, 1074-75 (9th Cir. 2002)</a>. Rather, Pierce argued that "the bankruptcy clause of the U.S. Constitution can
only be invoked by a bankruptcy debtor who is insolvent under a balance-sheet test...[because] the constitutional
grant of authority to Congress to enact "uniform laws on the subject of bankruptcies throughout the <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U… States,
U.S. Const., Art. 1, 8[4</a>], is limited to regulating the affairs of debtors who are insolvent in this sense." Marshall, WL22075703 (Bankr. C.D. Cal., Sept. 03, 2003). In other words, Pierce contended that insofar as the
Bankruptcy Code permits a solvent debtor to file bankruptcy, Congress has exceeded its powers granted by the
Constitution, and in such circumstances, the Constitution, and not the Bankruptcy Code, must govern.

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Pierce contended that insofar as the Bankruptcy Code permits a solvent debtor to file bankruptcy, Congress has exceeded its powers granted by the Constitution, and in such circumstances, the Constitution, and not the Bankruptcy Code, must govern.
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<h3>What Does Insolvency Mean?</h3>

In analyzing Pierce's argument, Judge Samuel L. Bufford first began with an analysis of the meaning of
insolvency. It was Judge Bufford's position that if insolvency was required by the Constitution in order to file
bankruptcy, he needed to determine what that term meant in the context of bankruptcy. Should insolvency be
determined by a balance-sheet test as urged by Pierce, or was the proper test the liquidity analysis in which the
individual or entity is not generally paying their debts as they come due?

Judge Bufford concluded there were a number of reasons why the balance-sheet test was not an appropriate test to
determine solvency in a chapter 11 proceeding. First, Judge Bufford found it was not uncommon for debtors to be
solvent under a balance-sheet test, but to have severe cash-flow problems. Second, Judge Bufford noted that
determining solvency under a balance sheet test was complicated, difficult and time-consuming to determine. As a
result, debtors would find it very difficult to reorganize if they had to prove insolvency under a balance-sheet test
before filing. Third, Judge Bufford believed that substantial economic value would be lost if debtors had to wait
until they were insolvent in a balance-sheet sense to file. Finally, Judge Bufford cited to the World Bank's
recommendation that the balance-sheet test should not be used to determine insolvency.<a href="#2" name="2a">2</a>

At the end of the analysis, Judge Bufford concluded that the liquidity test was the proper means to determine
insolvency, and it would be this test the court would use to determine whether insolvency was a constitutional
requirement for filing bankruptcy.<a href="#3" name="3a">3</a>

<h3>What Does History Tell Us?</h3>

Judge Bufford then turned his attention to the history of bankruptcy to determine if there was anything in the
records of the Constitutional Convention, the prior bankruptcy laws of the United States and England and past
Supreme Court holdings "that might shed light on the role of insolvency in the meaning of bankruptcies in the
bankruptcy clause." Marshall, WL 22075703 (Bankr. C.D. Cal., Sept. 03, 2003).

Judge Bufford found nothing in the Constitution's historical papers that would lend support to Pierce's argument
that the drafters intended bankruptcy relief to be restricted to insolvent debtors. Judge Bufford also found that the
history of U.S. bankruptcy law and its English law predecessor did not support the proposition that the bankruptcy
clause had been tied to insolvency. Only the 1841 and 1867 Bankruptcy Acts required a voluntary debtor to plead
insolvency based on the debtor's inability to pay debts as they came due, and once filed, this pleading could not be
challenged by anyone. Judge Bufford could find no bankruptcy law in the United States that ever required a
voluntary debtor to prove that he or she was indeed insolvent.

Judge Bufford further found that the insolvency requirements contained in the 1841 and 1867 Bankruptcy Acts were
not resurrected in subsequent bankruptcy laws involving voluntary debtors. It was not until the 1898 Act that
insolvency took any form of prominent role in bankruptcy, and that role was solely reserved for involuntary
bankruptcy petitions.<a href="#4" name="4a">4</a> Based on this history, Judge Bufford concluded "that, at the time that the Constitution was
written, insolvency of any kind as a condition for bankruptcy was utterly unknown. Thus it is not credible that the
framers of the Constitution thought that a requirement of insolvency was included in the concept of bankruptcy that
found its way into the bankruptcy clause." Marshall, WL22075703 (Bankr. C.D. Cal., Sept. 03, 2003).

Despite this finding, Judge Bufford did not end his analysis. Judge Bufford then turned his attention to the
developments of bankruptcy law since the inclusion of the bankruptcy clause in the U.S. Constitution in 1787.
Judge Bufford found that there were only three "watershed developments" in the progression of bankruptcy law as it
was known in 1787 when the bankruptcy clause was written into the Constitution, and none of the developments
involved insolvency.<a href="#5" name="5a">5</a> These changes were of a "fundamental and radically progressive nature." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… Joint
Stock Land Bank v. Radford, 295 U.S. 555 (1935)</a>, quoting <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… Illinois Nat. Bank & Trust Co. v.
Chicago, R.I. & P. Ry., 294 U.S. 648, 671 (1935)</a>. Nevertheless, the Supreme Court found these changes
constitutional. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 295 U.S. at 587-88</a>.

In contrast, Judge Bufford found that the filing of a bankruptcy case by a solvent debtor has never been debated and
has always been permitted under every bankruptcy law enacted in the United States and England. Thus, Judge
Bufford could not point to any significant historical development in bankruptcy law that changed what had always
been accepted as a general principal of bankruptcy law.

Judge Bufford concluded his historical review of bankruptcy by noting that "Supreme Court case law likewise gives
no support to the thesis that, as a constitutional matter, congressional power to provide bankruptcy protection must
be limited to those who are insolvent, whether under a balance-sheet test or otherwise." Marshall, WL 22075703
(Bankr. C.D. Cal., Sept. 03, 2003). In particular, Judge Bufford cited to the case of <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4… Labor Executives'
Ass'n. v. Gibbons, 455 U.S. 457, 466 (1982)</a>, in which the Supreme Court stated that "we have previously defined
'bankruptcy' as the subject of the relations between an insolvent or nonpaying or fraudulent debtor and his
creditors...." Judge Bufford noted for the record that at the very least, the debtors before him qualified as
"nonpaying" debtors as that term was used in Gibbons.

<h3>Conclusion</h3>

Judge Bufford ended Pierce's constitutional challenge by confirming the plan and finding that "Congress may
validly exercise the bankruptcy powers under the Constitution to authorize the filing of a chapter 11 case and to
confirm a plan of reorganization by a debtor who is solvent, whether in the balance-sheet sense or in the liquidity
sense." Marshall, WL22075703 (Bankr. C.D. Cal., Sept. 03, 2003).<a href="#6" name="6a">6</a>

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<h3>Footnotes</h3>

<a name="1">1</a> The court did not actually make a finding regarding the solvency or insolvency of the debtors, but instead presumed the debtors solvent for the purposes of determining Pierce's argument. <a href="#1a">Return to article</a>

<a name="2">2</a> The World Bank has found that businesses rarely reorganize in countries that use the balance-sheet test to determine insolvency. Instead, the World Bank recommends that countries use the liquidity test as a means to analyze insolvency. <a href="#2a">Return to article</a>

<a name="3">3</a> Judge Bufford acknowledged that Pierce had not urged the court to adopt the liquidity test in evaluating Pierce's constitutional challenge to confirmation. The court nevertheless assumed that Pierce was implicitly arguing that insolvency, no matter how it was determined, was a prerequisite for filing, and thus proceeded to examine the merits of Pierce's constitutional argument. Pierce most likely avoided the liquidity test argument because the debtors were not paying their debts as they came due, which may have defeated
Pierce's argument at the outset. <a href="#3a">Return to article</a>

<a name="4">4</a> This role remains today in the present form of the Bankruptcy Code as enacted in 1978 and modified thereafter. <a href="#4a">Return to article</a>

<a name="5">5</a> These developments were (1) the authorization for a debtor to file a voluntary bankruptcy petition, (2) the extension of bankruptcy protection to those individuals who were not traders and (3) the addition of reorganization as a mode of bankruptcy. <a href="#5a">Return to article</a>

<a name="6">6</a> Judge Bufford also disposed of Pierce's contention that the debtors' bankruptcy case deprives him of substantive economic due process rights. Pierce had neither property nor contract rights to assert against the debtors and in particular no claim against the debtors for the Texas judgment, since he had refused to file a claim in the case. <a href="#6a">Return to article</a>

Journal Authors

Deborah A. Crabbe

Journal Date

Saturday, November 1, 2003 - 12:00

Bankruptcy Rule

2003